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Archive for April, 2008

The efficient market hypothesis implies that, on average, active managers will not be able to outperform the overall market on a risk-adjusted basis, after fees. The implication of this is that, unless the manager has access to superior research analysts, portfolios should be managed passively. Passive management should result in lower fees for the same average performance.

Index funds are designed to passively mirror the performance of a given index, thus providing passive management.

Although there is no unified theory of behavioral finance, practitioners attempt to identify anomalies that can be explained by investor behavioral traits, and to identify opportunities to profit from exploiting the biases of other investors.

Value at Risk (VaR) has come to be regarded as the premier risk management technique for the financial industry. It measures the probability-based measure of potential loss that can be measured for specific transactions, business units or the total enterprise.

VaR estimates the loss in money terms that could be exceeded (i.e. it represents the minimum loss) at a given level of probability. For example, a $5 million one-day VaR at 5% indicates a 5% chance that losses could exceed $5 million on a given day.

All else equal, a higher loss has a lower probability of occurrence. Likewise, reducing the probability level from 5% to 1% (the two most common levels in use) would result in a higher VaR at the lower probability level.

If the weak form of the efficient market hypothesis holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Researchers testing weak form market efficiency generally use one of two groups of tests when studying weak-form market efficiency.

Statistical tests of independence measure either the significance of positive or negative correlation over time (autocorrelation) or by comparing the number of runs (consecutive moves in the same direction) with that expected in a normal sample. In general, statistical tests of independence have shown no relationship between current and future price movements.

Tests of trading rules seek to mechanically simulate various trading strategies. For example, testing whether a strategy of buying when the stock price closes above the 50 day moving average and selling when the price closes below the moving average. In general, these tests have supported the weak-form efficient market hypothesis by showing no excess returns (after trading costs, compared to a buy-and-hold strategy) from following such rules. However, the results are not unanimous – some rules have been shown to offer superior returns.

Technical analysts criticize the existing tests as being too naive or simplistic to capture the

Like private equity funds, hedge funds are typically organized as either limited partnerships or limited liability corporations to protect investors from losses exceeding their initial investment and to avoid double taxation of corporate earnings.

Compensation for hedge fund managers typically is based on two components:

A management fee of 1-2% of assets under management

An incentive fee of 15-20% of the returns in excess of a pre-determined benchmark. Incentive fees are usually constrained by features such as high-water marks, claw-back provisions and other features.

The high fees earned by hedge fund managers has been widely criticized, particularly when the returns generated include some exposure to beta. Beta can be obtained very cheaply through passive investments such as index funds. However, to the extent that the hedge fund returns offer diversification the fees may simply represent a sort of insurance premium that investors are willing to payÂ in exchange for risk reduction.

The investments made by hedge funds are often illiquid, and as such many funds require a lock-up period before investments can be withdrawn. In addition, most funds allow cash inflows and outflows only at specific times (usually quarterly.)

When selecting equity managers, it is important to verify that their stated practices are consistent with their actual results. Investors may wish to examine both qualitative and quantitative factors for this purpose.

Qualitative Factors

Investment personnel

Organizational structure

Investment philosophy

Investment decision-making process

Strength of equity research

Quantitative Factors

Performance relative to benchmarks and peers

Measures of style orientation and valuation characteristics of portfolios under management

Past performance should be taken with a grain of salt, as studies have indicated that few managers remain in the top quartile in repeated periods. As a result, managers are required to include a disclaimer that “past performance is no guarantee of future results.”

However, consistency of results can be important. In particular, a given level of performance will be highly valued if the philosophy, personnel and process behind it remained consistent over time.

The weak form of the efficient market hypothesis assumes that current stock prices fully reflect all security market information. Security market information includes historical price and volume data, as well as other market-generated information such as odd-lot trades and short interest.

If the weak-form EMH holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Enhanced index strategies attempt to add modest additional return while minimizing tracking risk relative to a benchmark index. In fixed income portfolios, the following factors are the primary contributors to tracking risk.

Portfolio duration – exposure to parallel shifts in the yield curve

Key rate duration – exposure to nonparallel shifts in the yield curve

Sector and quality – the percentage of bonds in the portfolio with given credit ratings, yields or sector exposures

Sector duration – exposure to changes in sector spreads

Quality spread duration – exposure to changes in credit spreads

Sector/coupon/maturity cell weights – a matrix design to put sets of securities into cells that largely replicate various qualities